Agreement between shareholders.
The primary objective of a shareholders' agreement is to protect shareholders against unforeseen circumstances while the business is thriving. The agreement acts as a "referee" to defend the interests of each business owner and their families. Since the business is typically the most significant asset for these owners, the ability to monetize its value in case of unexpected events is vital to meet their financial security needs and those of their loved ones.
A risk often overlooked:
disability However, another significant risk looms over the business: the long-term disability of a shareholder. If a partner becomes disabled for several years, they continue to benefit from the profits and future appreciation of the business, even if they can no longer contribute through their work to its growth. This situation, highly unfavorable for active shareholders within the company, often leads to disputes or litigation. Including a buy-back clause in case of disability helps prevent this scenario.
Once this clause is included in the agreement, it is imperative to establish a financing method for the buy-back of shares in case of disability. Otherwise, the prosperity of the business would be left to chance. Disability buy-sell insurance can finance this clause. It provides for a lump-sum payment or monthly benefit that can be used to repurchase the shares of the disabled owner, thereby avoiding the use of company assets or shareholders' personal assets for the buy-back. It also buys peace of mind.
Succession cases A buy-back clause clarifies the fate of a shareholder's shares in the event of their death. Buy-back clauses and mechanisms vary significantly from one shareholders' agreement to another. In some cases, other shareholders may buy the shares, while in others, the company itself will buy them. Ultimately, the purpose of the buy-back clause is for the remaining shareholders to retain control of the shares and pay the former shareholder or their heirs the fair market value of their shares.
Each shareholder should ensure that their estate plan reflects the buy-back clause included in the shareholders' agreement. Indeed, the buy-back clause prevents the shareholder from leaving their shares to their heirs.
Cases of reduced effort by a shareholder
It is important to define expectations regarding active shareholder participation in the company. If a shareholder reduces their involvement or no longer actively contributes to the company's growth, having a clause allowing for the buy-back of their shares is crucial to maintaining balance and harmony among the remaining shareholders.
Shareholder disputes - Shotgun clause
To avoid prolonged conflicts between shareholders, including a "shotgun" clause can be useful. This clause allows one shareholder to offer to buy the shares of other shareholders at a predetermined price. The other shareholders must then choose between selling their shares at that price or buying the shares of the shareholder offering at the same price. This clause facilitates quick resolution of conflicts by forcing a decision. It is customary to include a waiting period before the shotgun clause can be exercised. For example, the shotgun clause can only be used after one year of implementing the shareholders' agreement.
Sale of shares to another shareholder
The shareholders' agreement must also include provisions regarding the sale of shares to another shareholder. It is crucial to define the conditions and process of sale to avoid misunderstandings and conflicts. The clause should specify the method for calculating the fair market value of the shares and provide a dispute resolution plan in case of disagreement.
Cumulative capital gain exemption
Structuring the agreement to take advantage of available tax benefits, such as the cumulative capital gain exemption, is important. This exemption allows shareholders to sell their shares without paying capital gains tax up to a certain amount. Ensure your agreement considers this opportunity to optimize shareholders' tax benefits.
Has the company's structure changed? It is essential to review the shareholders' agreement following a reorganization, such as estate freezing or the addition or withdrawal of a shareholder. Ensure the document accurately reflects the company's structure to avoid surprises.
When was the last business valuation? In general, shareholders of private companies have a good idea of the value of their business. However, a professional business valuation of fair market value is often necessary, for example, when a shareholder sells their shares. The calculation of fair market value can be done using different methods. The shareholders' agreement should indicate the method agreed upon by all shareholders.
By specifying the calculation method, potential conflicts can be avoided if a shareholder wishes to sell their shares or buy those of another shareholder, as the shareholders' agreement will apply. Additionally, it may be prudent to include a dispute resolution plan in case of disagreement over the final valuation. To avoid amending the agreement every time the value is reviewed, adding an appendix suffices. It is also possible to include a clause authorizing adjustment of the value upwards or downwards if tax authorities disagree afterward.
Does your shareholders' agreement consider tax opportunities and restrictions? The shareholders' agreement should be drafted flexibly enough for shareholders to take advantage of tax provisions when applying clauses. For example, if funds need to be distributed to shareholders, the type of income chosen is crucial.
Here are some points to consider when drafting the shareholders' agreement, as they have fiscal implications:
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Citizenship of shareholders and beneficiaries of a shareholder trust, particularly if they are U.S. citizens;
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Tax residence of shareholders and beneficiaries of a shareholder trust;
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Family relationships, as defined by the Income Tax Act, between shareholders, including beneficiaries of a shareholder trust;
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If life insurance has been taken out to finance a potential share buy-back, specify how the capital dividend account will be used, for example, by indicating which of the surviving shareholders or the deceased shareholder's estate will benefit;
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As tax rules evolve constantly, clauses can grant some leeway to surviving shareholders and estate representatives to maximize those that will apply at the time of death.
What about your personal planning strategy? The shareholders' agreement is only intended to govern relationships between shareholders in the event of certain events. It provides no indication of how an estate will be distributed or how a shareholder's wealth will be managed if they become unable to manage it themselves.
Therefore, it is important for shareholders and their spouses to review their personal plans and legal documents, such as wills and powers of attorney, with the assistance of a professional legal advisor. These documents should be revised, as needed, based on the provisions of the shareholders' agreement.
These considerations provide a good starting point for reviewing and updating the shareholders' agreement, but it is essential to consult legal and tax experts specialized in preparing such documents. A good shareholders' agreement takes into account the economic, legal, and personal situation of each shareholder, as well as the unique characteristics of the business.
Does the company have a contingency plan? Even if the contingency plan is not part of the shareholders' agreement, it is advisable to establish both documents simultaneously and ensure all parties are aware of the existence of a contingency plan.
The contingency plan deals with operating the business in the event of an emergency affecting the management team. While the shareholders' agreement covers operations among shareholders, the contingency plan instructs the management team on how to ensure business continuity in case of disability or death of a director, when a situation requires prompt decision-making on their part.
In emergency situations, it is essential that resources are promptly available to take necessary actions and reassure clients, creditors, employees, and shareholders. Therefore, it may be wise to take out life insurance for key employees and directors solely to ensure business continuity.
A precise contingency plan for extreme cases and timely implementation mitigate uncertainty and tensions if a key company person is unavailable. For tailored advice and assistance in drafting or revising your shareholders' agreement, contact Twin Lisbet Law Firm, specialists in tax law and business law.